Surprised by Risk? The Danger of Chasing Yield
High-Yield Investments
In recent years, we have seen firms promoting and over-allocating toward high-yield investment strategies. For those living on fixed income, these are alluring as it can increase your portfolio yield and thus increase your income. Kings Path has tended to avoid these because of the inherent risk embedded in them (and the current tax indifference between dividends and capital gains). Sadly, these investments got hammered in the recent downturn leaving many investors wondering what happened to their retirement and “safe” portfolios.
If individuals were shocked by the performance of these types of funds this March, it is not that these investments did not behave as anticipated. It’s that individuals or their advisors either did not appropriately consider the underlying risks of their investments or over-allocated to these investments on a “chase for yield.” This is a problem, and it can be very damaging to a portfolio. Portfolios need to be designed with risk at the forefront of allocation decisions. If you were surprised by a sudden decline from your income-producing investments, perhaps it is time to take a step back and re-evaluate how your portfolio is built.
What is Yield Chasing?
With declining yields on traditional fixed income, “yield chasing” and “yield marketing” entered a dangerous cycle that unwound rapidly in the first quarter of this year as recession concerns accelerated and credit markets tightened. What do we mean by “yield chasing”? It is the phenomenon that we have seen over the last decade where investors (both individuals and institutional) absent-mindedly chase certain asset classes in search of yields. As global credit spreads have narrowed, we have seen this trend only worsen. Sure, it increases your portfolio’s current yield, but what also can happen?
Dangers of Yield Chasing
Markets in March 2020 and through COVID-19 illustrated the risks of yield chasing. The safety of dividends began to fall away as companies re-evaluated their capacity to pay dividends in a period of heightened economic uncertainty. Credit spreads rapidly widened as borrowers were viewed as more likely to default. And dividend yield strategies and high yield strategies were crushed relative to broader indices. Other high yielding asset classes such as MLPs and Equity Real Estate (REITs) experienced similar performance as high leverage (debt) and realized fears of renters not paying exasperated market volatility.
Performance YTD
How did these higher-yielding, income-producing, supposed “more-defensive due to good yield” strategies do when you needed them the most?
| Equity Index | Jan 1 to "Low" | Low Date | YTD (as of May 31, 2020) |
|---|---|---|---|
| FTSE High Dividend Yield Index | -34.3% | March 23 | -14.3% |
| Dow Jones All REIT Index | -37.4% | March 19 | -15.1% |
| Alerian MLP Index | -66.8% | March 19 | -30.2% |
| S&P 500 | -30.4% | March 19 | -5.0% |
| Credit Index | Jan 1 to "Low" | Low Date | YTD (as of May 31, 2020) |
|---|---|---|---|
| BBG Barclays High Yield Corp | -19.8% | March 19 | -4.7% |
| BBG Barclays Global Aggregate | -3.8% | March 17 | +2.2% |
A Diversified Portfolio
Does this mean you should not hold any of these asset classes? No! Investors just need to be cautious and understand the risk characteristics of these holdings. They can serve as part of a portfolio to add additional diversification and increase risk-adjusted return. But they should probably not constitute a “core” holding for any individual- certainly if you have significant market downside sensitivity.
Yield is interesting to investors because they like the income stream that it creates. In our opinion, since tax rates on long-term capital gains and dividends are essentially the same at this current time, investors should theoretically be indifferent to the source of income. You should instead focus on maximizing your risk-adjusted return, and then scale your risk appropriately.
Portfolio design starts with understanding the risks of your investment options. Minimize surprise and build a portfolio in which you will have confidence over the long run.
If you have felt the impact of this past March’s volatility on your portfolio and need some help thinking through your portfolio design, please feel free to reach out to us. We can help you understand the risks within your portfolio and how you may better design a portfolio to help achieve your return objectives while seeking to minimize your risks.
